China’s quantitative approach to monetary tightening has almost certainly reached its limit. Between 2004 and now, the share of FX (foreign exchange) reserves sterilized by required reserves and open market operations declined from nearly 100% to around 80%. Meanwhile, the required reserve ratio was raised from 7% to an unprecedented 20.5%. Yet, China’s economic circumstance demands even more.

In Q1, liquidity added via FX reserves accounted for 40% of new broad money supply. If China were to sterilize even 80% of that, then the RRR (required reserves) would need to be set at 32%. Such a level would cripple the fluidity of the banking system.

China has some room to do this because the US dollar is so low against everything else including the Euro and other currencies.

In the first quarter of this year, China's Producer Price Index (PPI) and industrial producers' purchase price index rose 7.1 percent and 10.2 percent respectively. The pressure for the raw materials price hikes transferred to down-stream sectors is mounting.

According to a research by ANZ Bank, if the RMB exchange rate against US dollar appreciated by 10 percent, the PPI would drop 3.2 percent in the mid term, and the non-food prices in the CPI basket would fall 0.64 percent.

The ANZ Bank said that China may resort to foreign exchange rate policy to curb imported inflation, including speeding up the pace of RMB appreciation and broaden the daily fluctuation band for RMB trading.

An exchange rate move to 5.8 by the end of 2011 would increase China's GDP in US dollar terms to 7.58 trillion (7.8 trillion including Hong Kong).
If the exchange rate was 6.0 then it would be 7.33 trillion (7.53 trillion with Hong Kong).